Seed-stage Equity is for Suckers: Let's fix that.
The classic Silicon Valley success story starts at the seed-stage. A few people, in a garage in Palo Alto or unheated warehouse in Soma, working on ramen wages and dreams of a big equity pay out. It's part of the lore and part of the appeal of tech and startups generally.
The hard truth is that joining a seed-stage company is almost never a good idea financially speaking. I think the risk that founders take in starting a company is typically well compensated for, but the same cannot be said for early employees.
With that said, there are a lot of other reasons to join a seed-stage company, but equity needs to be fixed to ensure early-stage companies have access to all the talent they need.
Look: I don't want to be the Series B, recruitment tech exec ragging on seed-stage startups. I know how hard it is to hire great people at any stage, but especially at the seed stage. The goal of this post is to start a conversation on how seed-stage startups, as a whole, need to think about seed-stage employee equity compensation. Seed-stage companies lack cash and need equity to be a motivator for talent. We need to fix it and make it compelling again.
Here are the problems with treating seed-stage equity the same way we treat equity at all other stages of startup growth:
- Grants are too small: Even 1% of equity at the seed-stage will get heavily diluted before there is an exit. Moreover, the risk at seed-stage, where product market fit is still a pipe dream requires much higher equity compensation for the founding team.
- Vesting doesn't make sense: It is very rare for a startup that is successful to have the same need for the generalist talent from their seed stage at the Series B+ stage. 4 years to vest just does not make sense for early employees and does not accurately recognize their valuable early contributions. Moreover a 1 year cliff also does not line up with early contributions by employees in the early days, some of whom may not make it the full year for reasons out of their control.
- 3-months to execute options post-termination is too short
- 10-year time period to execute options, whether employed or not, is also too short.
- Executing large grants of equity is costly and risky for employees
- Onerous terms to liquidate your equity: Some companies don't allow for individual secondary sales. You can only sell some of your shares if the company's board allows it, which is arbitrary.
- On top of product and execution risk, there is corporate oversight risk when the board only consists of founders or where the board is defacto controlled by only the founders.
Let's think of a rosy case: You picked the right seed-stage company! You raise an A and have some product market fit. You've just been diluted 20% and maybe just hit your cliff for your first 25% of equity. Your role changes, now you aren't a generalist but need to be shoe horned into sales or customer success. Series B comes around, yeah! More dilution, another 20%. Now the new VP of Revenue needs to hire true sales people. Specialists. That isn't you. You get laid off in a strategic around of lay-offs. You now have 3-months to execute your options. Lets say you did get a big grant, maybe its 20-50k you need to lay out to buy your options. What do you do? Moreover, if you do hang on, most companies wont have an exit for at least 7 years. That's the mean, some (like the most successful) might not have an exit for 10+ years. You are going to need to execute your shares before there is liquidity.
Right off the bat, even if you happen to pick a winner, which is hard to do at the seed stage, there are a bunch of compounding factors that limit your ability to capitalize on the success of the company.
First, I don't think equity compensation is totally broken. I think the way things are work pretty well for some Series A and most all Series B+ companies. I don't think at those stages things are really broken. Those companies also tend to pay much better than seed stage companies, so the equity is less of a factor. You have less risk because you are being paid real money as a base salary.
Second, I'm not a lawyer. I'm not even really a HR professional. Changing the way things are done will be hard and very costly for individual companies. We need what YC did with the SAFE: An open source, legally vetted set of documents for seed stage specific equity.
Finally, to riff-off of the first point: The ideas below are perhaps only ideas valid for your first employees. Those you hired right after seed up until you are raising or have raised a Series A. We need to solve for the very early risk-reward imbalance, not for all employees ever hired by the company. What I propose is a special set of terms just to attract top talent to the seed stage and reward them appropriately.
Solving for the size of grants:
A standard equity pool at the seed stage is maybe 7-10% of the company and it is almost never full utilized. You need space on the cap table to hire people, so blowing all of your equity is rarely sensible. A few folks will get 1%, most will get less than a .5%.
First proposal: Double the size of the initial equity grant pool and, likewise, double the average grant size for early stage employees.
VCs have to get on board with this to make it happen. In effect, it means less equity for founders and for the early VCs, but by creating materially larger grants, you will increase the ability to land top talent, while preserving cash, and increasing the chance of execution success. That is worth the cost.
Solving for vesting:
Early stage employees are living in a fast developing ecosystem. Every day matters. What happens in the first year, determines whether the company can raise another round and be successful. Equity should vest according to the value the employee is delivering at the crucial time they are delivering it.
Second proposal: Seed-stage employees should cliff at 6-months and grants should be vesting over 2 years.
VCs and founders will have to agree to larger grants that vest earlier which means more real equity will be going out the door. As with the first point, this will create better incentives for those first employees to join, de-risk the chance that future growth will limit their ability to stay at the company and earn their full grant.
Time to execute options post-employment:
The standard 3-months to execute options post-termination means that many employees will have a short window usually at still an early, risky stage of the company to execute their options. Executing options takes real cash and is a real investment with real risk.
Third proposal: All seed stage equity grants should have a minimum of 7-years to execute their options regardless of whether they are employed or not.
This has already become fashionable at top companies in the YC network. It should be standard for at least all seed stage grants.
Time to execute options:
We have already seen some companies, like AIRBNB and Palantir, take a long time to reach a liquidity event with some employees who are still with the company reaching the 10-year mark on their initial equity grants.
Fourth proposal: Seed stage employees should be guaranteed a secondary sale after 5 years or have their initial grant reissued in full for another 10 years.
The above companies did right and were able to offer a secondary sale to early employees before their grants expired. It should be baked in early to communicate clearly to employees that their early stage grants will have a chance to be valuable if the company is successful but requires additional time for an exit. There are legal considerations that could be solved here (ISOs have a legal requirement of 10-years maximum to be executed). In lieu of government action, startups should be creative so that these arcane rules don't impact their early employees.
Executing equity options cost real money:
If you are early and you got a large equity options grant, you still need to fork over the strike price to take possession of the common shares.
Fifth proposal: Companies should provide a vesting bonus to account for the cost of executing their shares as well as for the tax consequences of the share execution to employees who make it to the end of their grant or who are terminated before the end of their grant in good standing with the company.
The tax costs are real money, but the cost to execute the shares goes right back into the coffers of the company when they are executed. Some employees will choose not to execute and just take the cash, in effect getting the 409a valuation of their shares as compensation for their early contribution. In those cases, the company still gets the equity back which will likely be more valuable than the cash bonus.
No right to sell equity on the open market:
Many companies do not allow their employees to sell their equity outside of board sanctioned secondary sales. This means that early employees are forced to have material wealth locked up in equity they have no control over.
Sixth proposal: All seed stage employees should be allowed to sell their equity at-will with limited and previously enumerated limitations of who they cannot sell to (like a competitor).
I get that the board and C-level want to have clean cap table, but I think this completely disregards the needs of the early employee to realize value from their earlier forgone wages. Perhaps this consideration is only for early employees to limit the impact on the cap table (which will likely be just 10-20 folks), but allowing for employees to actively seek buyers for their equity will greatly increase the perceived value of early-stage equity.
Adequate board oversight:
Early companies typically have informal boards, which can impair the fiduciary responsibility of the board to ensure the company is being run with appropriate oversight.
Seventh proposal: Early stage companies should have balanced boards made up of 50% founders and 50% current employees or investors.
Boards are tricky and can slow down execution. At the early stage, there are benefits to having few people being able to make decisions and move quickly. With that said, boards need to provide oversight and in lieu of external board seats that constitute at least 50% of the voting board members, early boards should be augmented with senior non-founder employees with 1-2 year term limits.
There are implications to all of the above and some things may literally not be possible. Going with the kitchen sink will have consequences that are unforeseen and could cause issues with the viability of the company. With that said, seed-stage equity needs to change. Seed-stage employees are foregoing cash compensation and taking on serious risk for the privilege of joining something new. They need to be more adequately compensated with better equity terms, while being modestly de-risked.
If we can change seed-stage equity grants, will have access to better talent and more startups will be successful. More early-stage employees will be able to leave and start their own companies creating fertile ground for more innovation. It needs to happen or else the FAANGs and other behemoths will suck up the best and leave founders with only the scraps, when what they need most in the early days is the best to succeed.
We can fix this. I needs to be fixed.